We investigate the effect of changes in capital regulation on the strictness
(leniency) of loan terms using a simple model of bank capital requirements and
asset quality examinations. Banks offer different levels of "leniency" in the sense
of willingness to offer automatic extensions of loans in the presence of temporary
payment difficulties of borrowers. Banks offering lenient (less strict) loan terms
must have higher initial levels of capital and charge higher loan rates. When
capital requirements are increased, both strict and lenient banks hold higher levels
of initial capital and they raise loan rates. As capital requirements increase the
difference between initial capital levels and between interest rates of strict and
lenient banks decrease. Thus, higher capital requirements in recessions tend to
reduce the interest rate premium paid for leniency. If a recession is interpreted as
an increase in the required return, the interest rate premium paid for leniency is
increased in recession at a given level of required capital.

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In 1992 the Cadbury Committee report on the financial aspects of corporate governance was
published. The Committee had been established following the failures of a number of high
profile businesses in the UK which had shaken confidence in the market. Some nine years
later, in 2001, the collapse of Enron sent shockwaves through the US market. As a result of the
Enron collapse and various other high profile scandals in the years since its occurrence, the US
is examining its own corporate governance structures and provisions to determine how these
might be improved and help avoid another Enron. The EU similarly is developing principles
and legislation to improve corporate governance, and scandals such as Royal Ahold and
Parmalat have helped drive further governance reforms.
In this paper we detail the development of corporate governance codes in the UK and the
adaptation of similar codes in the EU. We discuss the role of the financial sector in corporate
governance and how principles for regulation and supervision of the financial sector
complement codes of conduct and legislation in the area of corporate governance.
JEL Classification numbers: G34, G28, G22, G23
Keywords: corporate governance, financial sector; institutional investors.